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No Nuance

No nuance is needed to show
Price pressures are starting to grow
And as an aside
Poor Goldilocks died
For shareholders, look out below!

In the wake of yesterday’s surprisingly high CPI print, on both the headline and core measures, the immediate impact was equity futures sold off sharply. This made sense given the heightened concerns that the market has been showing with regard to inflation ever since the AHE number surprised on the high side two weeks ago. So the CPI was now the second piece of important inflation data that was pointing to the Fed being forced to raise rates faster than they currently assume (3x in 2018) and much faster than the market is currently pricing (~2x in 2018). In fact, a Bloomberg survey of economists now points to the median expectation of Fed rate hikes this year having moved up to four while the Fed Funds futures market has moved up to a 25% probability of a fourth rate hike this year.

However, by yesterdays close
The market, its fear did transpose
As rates keep on rising
It’s now emphasizing
How fast the economy grows

It seems, however, that the bulls will not be denied. By the time the equity markets closed yesterday afternoon, stock prices were up ~1%, the dollar had resumed its decline and commodity prices were rising; all while Treasury prices continued to fall. There seems to be a pretty big disconnect between the way asset markets are trading and the increasing probability that global QE is going to disappear sooner than expected. My friend Mike Ashton (follow him on Twitter at @inflation_guy), who really does seem to know everything about inflation, makes the point that because of the comparisons over the next six months, Core CPI is likely to be up to 2.5% or even higher come late summer. If that is the case, and it certainly seems reasonable based on the data, ask yourself how relaxed the FOMC will be about that gradual pace of rate increases. My view is that even the doves will be forced to admit that rates need to move higher if the data begins to show the Fed is truly behind the curve. And so, I continue to look at the current broad market price action and scratch my head. A perfect example is that the correlation between the yield on 2-year Treasuries and the dollar, which historically has run above 60%, has fallen to 23%. That is emblematic of the change in views we have seen. It is also ripe for a return to historical values as more stress builds in the market. After all, equity markets that have been built on unlimited free liquidity cannot sustain the same levels when liquidity shrinks and is no longer free. Last week was, I believe, just a taste of what we will see during the rest of the year.

But for now, the market continues to whistle past that graveyard and the narrative remains, gradual rate rises will not impact the synchronous global growth story, earnings will continue to be amazing, and equity prices, alongside commodity prices, will continue to rise.

And the dollar? Boy they hate the dollar. In fairness, there is a clear negative fundamental, the growing twin deficits (budget and current account), which ought to undermine the dollar’s value. And of course, given the recent breakdown in the correlation with interest rates, there is nothing to offset that right now. With this in mind, it is no surprise that the dollar remains under pressure and has fallen further overnight. Can it continue? My view remains that the dollar will find its footing as the year progresses, but right now that is a distinct minority position.

So let’s take a look at the overnight activity in FX. As mentioned, the dollar is down across the board. In the G10 space, the biggest gainer has been the pound, up 0.5% and back over 1.40, although the Swiss franc has had almost the same magnitude movement. Interestingly, there has been no specific news in either one, or comments from officials that would seem to drive things. In fact, the only comment of note overnight was from Japanese FinMin, Taro Aso, who said that recent yen movement has not been severe enough to consider intervention. Not surprisingly, the yen is firmer by 0.3% and is actually now at its strongest vs. the dollar in more than a year.

Moving to emerging markets, we have seen strength across the board here as well, with ZAR continuing to benefit from President Zuma’s finally having resigned, and the APAC bloc virtually all stronger vs. the dollar as they head into the Lunar New Year celebrations. Local equity markets have been rebounding from last week’s sell-off and it is clear that investors are actively buying those currencies to get back into the trade. With the holiday now upon us, I expect this bloc will see limited action for the next couple of days, but both EEMEA and LATAM are likely to continue to trade with the broad narrative. I’m not sure what will change this view, but I am increasingly confident that something will do so in the near future.

On the data front today, we have a bunch of stuff as follows: Initial Claims (exp 224K); Empire Mfg (17.2); Philly Fed (21.6); PPI (0.3%, 2.5% Y/Y); Capacity Utilization (78.0%); and IP (0.2%). Given the market response to yesterday’s data, I would think the only thing that can derail the bulls would be information that the economy is fading, so much weaker Empire or Philly data, or surprisingly weak IP. Of course, that would simply encourage the bulls to point to the lack of pressure for further rate hikes.

Chairman Powell has a challenging time ahead of him as the market seems almost to be daring him to raise rates more quickly than currently assessed. I have to say that we have not heard any concerns from the Fed that the recent increase in market volatility is an issue, and so my take is the Fed will pick up the pace as the data presents itself going forward, and that volatility will continue. And in the end, increased volatility equals risk-off equals a stronger dollar. It just may take a little more time to get there.